We've Been Worrying About the Wrong Deficit

April 30, 2014

Crap, the economy is stagnating again.

At least, that’s what new GDP data from the Bureau of Economic Analysis indicates. The economy grew just 0.1 percent in the first quarter of the year, but all is not lost. Personal consumption expenditures—what Americans spend on goods and services—were surprisingly strong, with 3 percent growth.

The subpar data has two main causes: domestic investment and trade. The former includes business investment in things like structures, equipment and intellectual property along with inventories and residential construction. The latter reduced growth by 0.83 percent in the first quarter of this year, after adding 0.99 percent to growth at the end of 2013. Severe fluctuations like that most likely indicate a timing issue, where payments for goods and services were recorded one quarter later. But it raises an important point nonetheless: One of the most consistent impediments to full employment is the trade deficit.

The trade deficit (trade surplus when it is positive) is the difference in U.S. exports minus U.S. imports. In 2013, it was negative $475 billion, equal to three percent of GDP. That means we imported $475 billion worth of goods and services more than we exported. This hurts domestic growth, because American demands for goods and services is producing growth overseas. In the same way, foreign demand for American goods and services is good for the U.S. economy. That’s why the Obama administration has focused on increasing exports. It creates jobs at home.

The administration succeeded in narrowing the deficit slightly in 2013 thanks to increased domestic energy production, but the nearly $500 billion gap remains. This is a massive drag on growth, as economist Dean Baker explained in a recent paper. He estimated that eliminating the trade deficit would directly create 4.2 million jobs and another 2.1 million through multiplier effects—the 4.2 million people will spend more money, creating more jobs and so on.

But reducing the gap isn't so simple. Protectionism, which has fallen out of favor among economists, is not the answer. The U.S widely benefits from the global economy and has had a deficit for decades now, experiencing periods of strong growth during that time. But other countries take advantage of the system by manipulating their currencies and artificially lowering their value. This boosts their exports, but it also makes American goods and services comparatively more expensive, reducing U.S. exports.

The threat of sanctions or tariffs against currency manipulators could help lower the dollar’s value, and thus, the trade deficit. Baker also suggests taxing foreign dollar holdings to convince them to sell off dollars, thereby reducing the currency’s value. But there are also complicated geopolitical considerations that the White House must balance outside the realm of economic policy. Japan is a key ally in the Pacific that also happens to be one of the world’s biggest currency manipulators. Labeling China a currency manipulator could provoke a damaging trade war.

In other words, the problem is easy to identify, but difficult to solve.